Types of profitability ratios
Margin ratios
As previously noted, margin ratios are a measure of how a company converts revenue into profits. The most common margin ratios are gross margin, operating margin, and net profit margin.
Gross margin compares gross profits to revenue. The core factor in determining gross margin is cost of goods sold. It only factors in costs directly related to the products sold and no other expenses in the business. If a company has a high gross margin relative to its peers, it's an indication that it's able to charge a premium for its products. Declining gross margins across the industry could indicate increased competition.
Operating margin compares operating profit to revenue. On top of cost of goods sold, operating profit also factors in standard operating expenses such as marketing, sales, general, and administrative expenses. It doesn't include things like interest on debt or income taxes.
Operating margin is a good measure of how efficient a company is in its operations. A fast-growing company may have a small or even negative operating margin, but it ought to show improvement over time as it scales revenue. Operating margin is also used to assess the quality of management since good management will find ways to improve profitability and efficiency.
Net profit margin takes a company's bottom-line profits divided by revenue. It takes everything into account, including taxes and interest. If a company has a big debt load or high interest rates on its debt, it will show up in its net profit margin. If it can minimize taxes, that'll show up, too. However, investors should be aware of any one-time expenses or gains that might create anomalies in the net profit margin.
Return ratios
Return ratios measure how well a company uses its balance sheet -- one of the three main financial statements -- to generate profits. There are two return ratios for investors to pay attention to: return on assets and return on equity.
Return on assets looks at how well a company uses its assets and investments to generate income. A company that can deploy its assets effectively to generate a profit will do better than a company that's less efficient with its assets. An improving return on assets may indicate a company is seeing improved economies of scale as the business grows.
